Inflation: Making The Complex, Simple - Part 1

While we think the odds of sustained inflation are small, we must be prepared nonetheless. If inflation proves temporary and fades within months, assets being shunned today like long-term bonds and possibly gold offer sizeable returns. If we are wrong, investments that benefit from inflation like miners and energy companies should do well. Regardless, we are on guard for either scenario.

Preparation, first and foremost, involves understanding the drivers of inflation.

 

The Price of a Big Mac

The price of a McDonalds Big Mac is always expressed in relation to a currency. For instance, in the United States, the price is $4.25.

Like a football play, $4.25 is a simple summary of something more complex. To raise the complexity, we can fractionalize the price to 4.25/1. Whereas 4.25 represents the number of dollars required to purchase 1 Big Mac.

We can further expand on the numerator (dollars) and denominator (1 Big Mac) with the following formula: SD($)/SD(BM). The supply and demand for dollars over the supply and demand of Big Macs.

Now consider, regardless of the supply or demand for dollars and Big Macs, the denominator is always one. A dollar is always worth 1.00. Accordingly, the numerator (dollar price) changes to reflect fluctuations in the supply/demand functions of the dollar and/or the Big Mac.

What happens to the price of a Big Mac if the dollar is devalued by 50%? Despite the cheaper dollar, it is still worth $1. Therefore, only the numerator can change to reflect a price change. In this case, we would expect the price of a Big Mac to double.

 

In Aggregate

We could devote pages to the multitude of factors affecting the supply, demand, and pricing of a Big Mac. The exercise would explain why the Big Mac price rises or falls versus Burger King Whoppers and every other good and service available. Such analysis is critical to McDonald's but often overemphasized from a macroeconomic perspective.

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